Labour Sponsored Investment Funds - Contravention of Spirit and Intent

This publication is provided as a guide only. It is not intended as a substitute for subsections 18(12), (13) or (14) of Part III of the Community Small Business Investment Funds Act.

About this publication

This publication addresses the provisions dealing with contravention of the spirit and intent of the Community Small Business Investment Funds Act (CSBIF Act), which became law on December 16, 2004.

Purpose

The intent of the CSBIF Act is to facilitate the growth and development of small and medium-sized Ontario businesses through the provision of venture capital. Certain investments made through the Labour Sponsored Investment Funds (LSIF) program may violate the spirit and intent of the program, though they may meet the legal requirements of the act. Penalties for violating the spirit and intent of the CSBIF Act are also explained.

Fundamental principles

To determine if an investment contravenes the fundamental principles of the LSIF program, the minister shall consider spirit and intent factors that are, in his or her opinion, relevant. Subsection 18(14) of Part III of the CSBIF Act provides guidance regarding these factors.

These factors require that:

• LSIFs provide capital and managerial assistance to small and medium-sized Ontariobased businesses with the objective of supporting the growth of those businesses
• recipient businesses must have unrestricted access to capital invested for the operation and development of the business
• a material portion of the economic value of the LSIF investment shall be derived from the eligible business
• if an investment has been made indirectly through a subsidiary of the LSIF, the subsidiary shall make a reasonable attempt to invest in small or medium-sized Ontario businesses
• investment proceeds are used by eligible businesses before the LSIF disposes of its investment.

The above list is not exhaustive and is only meant to act as a guide. Whether a particular investment contravenes the spirit and intent of the act will be determined on a case-by-case basis, taking into account all the terms and conditions of the transaction documents, and the circumstances surrounding the transaction or series of transactions.

Unrestricted access to capital

Under the terms and conditions of the transaction documents, a recipient business must have unrestricted access to the capital provided and must have signing authority and control over the funds. While certain limitations may be placed on the use of the capital, any restriction must have a legitimate business purpose. For example, placing limits on the extent to which the funds may be used for management bonuses would be considered to be a legitimate business purpose. However, placing the capital in escrow to be released only when approved by the LSIF, would not be considered to be unrestricted access. Funds that are released when certain milestones are reached by an eligible business will be counted towards the LSIF's investment requirements, when the funds are released to the recipient business.

Economic value of the investment

Whether a material portion of the economic value of the investment is derived directly or indirectly from a business other than an eligible business would depend on the circumstances and details of the investment. Although the use of convertible securities is permitted, the following factors may suggest that the spirit and intent of the program have not been met:

• The terms and circumstances of the transaction and the timing of any subsequent exchange of securities suggest that the LSIF did not intend for its investment to be used in the operations of an eligible business, whether or not this business is part of a larger entity that includes operations in an ineligible business or operations outside Ontario.
• The proceeds provided by the LSIF are used indirectly to finance an ineligible component of the business. Any payments that flow from the eligible business to an ineligible business must be on the same terms as an arm's-length third party transaction.

Indirect investments

The CSBIF Act permits LSIFs to make eligible investments in holding companies. An investment in a holding company would not violate the spirit and intent of the act if, within a reasonable number of days after the investment is made by the LSIF, all or substantially all of the funds invested by the LSIF are reinvested in a business that would be considered eligible. Where the funds are not successfully reinvested, the minister would examine the terms of investment to determine if the original intent was to make an investment in an eligible business.

Material portion of proceeds

Whether capital invested by an LSIF in an eligible business is used for operational purposes is a decision to be made by the business. However, where a material portion of the capital is returned to the LSIF without being used in the operation of the recipient business, the timing and circumstances of the return of the capital, as well as any restrictions placed by the LSIF that may have effectively prohibited the business from using the funds, would be examined.

Examples:

1. The LSIF enters into a loan agreement with the business investee that has two different rates of interest, with a higher rate charged for funds to be used for operational purposes. The LSIF would be considered to have effectively restricted the business from using the loan in its general operations.
2. A loan agreement with the business investee that allows the LSIF to call in the loan at any time, except for circumstances such as financial distress, is another example of a condition that would effectively prohibit a recipient business from using funds in its operations.

Consequence to the LSIF

If an LSIF investment has contravened the spirit and intent of the act as a result of a transaction or series of transactions, the minister shall make an order that the investment is not an eligible investment for purposes of determining compliance with the program's investment requirements. This will be effective from the date of the transaction, or the date of the first transaction in a series of transactions. Following the order, the minister may also serve a notice of proposal to revoke the registration of the LSIF. If the LSIF does not agree, it may serve the minister with a notice of objection within 60 days after the date the proposal was mailed. [ss 26(1) and 31(1)]

Penalties

The minister may assess a penalty against every person (other than an employee of the LSIF) who acts as a fund manager of, or investment advisor to, that LSIF. [ss 18(13)]

The penalty is calculated as 1.5 per cent of the amount paid by the LSIF in the transaction or series of transactions leading to the contravention. The maximum penalty for the first contravention is $50,000. For each subsequent contravention, the penalty is calculated at 3 per cent of the amount paid by the LSIF in the transaction or series of transactions. The maximum penalty for subsequent contraventions is $100,000.

Investment advisors may be subject to penalty

Fund managers and/or investment advisors who have the power or responsibility to direct the investment affairs of the LSIF, or who advise the LSIF on the investing in, or the buying or selling of securities may be subject to this penalty.

Members of boards of directors may be subject to penalty

Members of boards of directors of LSIFs may also be subject to penalties as they have the ultimate responsibility of overseeing the affairs of the fund. Members of the boards of directors would only be penalized if a board member knew or ought to have known that the LSIF was engaging in offensive transactions and failed to take reasonable steps to stop the LSIF. [ss 18(13)]

Individuals not subject to penalty

Employees of fund managers or investment advisors would not be held personally liable. Lawyers, accountants, and others who provide professional services other than investment advice to LSIFs would not be considered to be investment advisors.

Requests for written interpretations

Binding interpretations on whether an investment contravenes the spirit and intent of the CSBIF Act can only be made by reviewing all the facts outlining the structure and details of the intended investment. Where all relevant facts are provided, requests for written interpretations may be sent to:

Ministry of Finance
Tax Advisory Services Branch
Income Tax Related Programs Section
33 King St W
Oshawa ON  L1H 8H5

Related publications

Other publications which provide further details on this topic include:

• CSBIF Listing
• Notice of Objection - Community Small Business Investment Funds Act [PDF - 105 KB]
• Information Bulletin – LSBIF
• LSIF Guide
• LSIF Listing

More information

To obtain the most current version of this publication, or additional information, visit our website at ontario.ca/finance and enter 2548 in the find page field at the bottom of the webpage or contact the Ministry of Finance at:

• 1 866 ONT-TAXS (1 866 668-8297)
• 1 800 263-7776 teletypewriter (TTY)